Posted by on Feb 15, 2011 in Blog, Columns, Featured |

By Jason Zweig | Feb. 12, 2011  12:01 a.m. ET
Image Credit: Christophe Vorlet

Is James K. Glassman right this time?

The co-author of Dow 36,000 — which was published near the peak of the Internet bubble in 1999 and called for stocks to triple in as little as five years — is rolling out a book warning investors to protect themselves against another round of financial disasters.

In his new book, Safety Net, Mr. Glassman writes the three words that are hardest for any investor or financial pundit to utter: “I was wrong.” He deserves some credit for that admission.

 Oddly, though, Mr. Glassman may not be exactly right about what he got wrong. His attempts to reconcile his earlier views with today’s realities shed light on a crucially important question: What does it mean to say that an investment is “risky”?

Dow 36,000 was published on Oct. 1, 1999. Co-written with economist Kevin A. Hassett, the book contained some sensible, eat-your-vegetables advice: diversify, trade as seldom as possible, keep your costs low and favor index funds.

But the main argument of Dow 36,000 was dubious.

Three days before Dow 36,000 came out, Foundry Networks, a computer-infrastructure firm, went public; its shares shot up 525% on their first day. Over the preceding five years, U.S. stocks had gained an annual average of 25%. Nevertheless, “stocks could immediately double, triple or even quadruple and still not be too expensive,” wrote Messrs. Glassman and Hassett.

Their logic? “Stocks and bonds are equally risky over long horizons,” because stocks had never lost money over the long term, and the passage of time made their rate of return almost constant. Furthermore, investors had started “learning” that stocks weren’t risky.

Mr. Glassman insists his argument wasn’t radical. In one way he is right: Economists contend that riskier assets must offer higher returns, or no one would invest in them.

That is a fallacy, says Howard Marks, chairman of Oaktree Capital Management in Los Angeles, which manages more than $80 billion. Mr. Marks is author of a superb forthcoming book, The Most Important Thing, that helps explain risk clearly.

Riskier assets don’t necessarily offer higher returns, Mr. Marks says; they only appear to do so. “It’s really simple,” he says. “If risky investments could be counted on for higher returns, then they wouldn’t be risky. And if investments weren’t risky, then they probably wouldn’t appear to promise higher returns.”

By chasing the potential for higher return in riskier assets, investors drive prices up. Under the classic definition of risk — how widely the returns deviate from the average — that alone doesn’t make assets more dangerous. But by Mr. Marks’s common-sense definition of risk — “the likelihood of losing money” — rising prices are pure investment poison. The higher and faster prices go up, the farther and harder they have to fall.

That wasn’t Mr. Glassman’s view in Dow 36,000. “I was holding to what I believed was a very rational argument based on the data,” he says now.

Yet his central view doesn’t seem terribly different today. “The data [still] show that stocks aren’t risky,” he says. “But the world has changed.”

Mr. Glassman cites factors like terrorism, slower economic growth in the U.S. and the recent “flash crash” as evidence of “a real change in the amount of danger that exists in the world.” Therefore, argues Mr. Glassman, investors should cut their allocations to stocks, load up on bonds, buy foreign-currency funds and hold “inverse” exchange-traded funds that seek to go up when stocks fall.

Is the world more dangerous than in 1999, when the “Y2K” glitch threatened computer networks, schoolchildren were massacred at Columbine and wars raged in Kosovo, Rwanda and Sierra Leone?

Who knows?

Mr. Glassman says investors should hedge their portfolios against what he calls “bolt-out-of-the-blue risks,” but that has always been true.

And no holding period is long enough to eliminate the risk of holding stocks. Research from Elroy Dimson, Paul Marsh and Mike Staunton of London Business School shows that stocks world-wide have sometimes lost money, after inflation, for many decades, as in France from 1912 through 1977. I doubt such a long slog will happen here, but it isn’t impossible.

The risks of owning stocks are real, and they are rising — not falling — as stock prices keep going up. That doesn’t mean you should reduce your exposure to stocks. It does mean the more they go up, the less you should like them.

Meanwhile, cash is moving out of municipal bonds and emerging-markets stocks as their prices fall. If that keeps up, they will get less risky, not more — and more attractive, not less.

Source: The Wall Street Journal


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